COVID-19 Market Update
This week has been bad for equity markets across the world. Whilst the absolute fall is no worse than markets usually experience during a calendar year, the pace and ferocity of the fall has been unseen in markets since the dark days of the financial crisis in 2008.
The primary cause of this selloff has been the spreading of Covid19 outside of China, to the rest of Asia, Europe and North America. Whilst case numbers remain muted in most places apart from China, the virus is starting to wreak some quite severe economic damage. The brunt of this has been felt by China which has effectively been in self-imposed quarantine for the last month. The result of this is that conventional economic indicators that indicate manufacturing and services activity have plunged to record lows as the below graph shows:
Other more unconventional measures such as the amount of nitrogen dioxide in the atmosphere over China also point to a sharp slowdown in economic activity:
Whilst there are few tangible signs that economies are slowing in the West, if the virus continues to spread then it is likely that there will be a slowing of growth. The world economy is in a relatively strong position though and it seems that any impact is likely to be felt in the first few quarters of this year with a sharp bounce back in economic activity in the latter part of the year. Governments and Central Banks remain alert to the risk and so it is likely that we will see further interest rate cuts across the world coupled with looser fiscal policy by many governments. This will undoubtedly be good for equities in the medium term.
Whilst it is easy to get caught up in the hysteria of it all, especially when it is whipped up by the media, it is important to try and think rationally about the situation that we find ourselves in.
The media tend to report headline figures for the number of cases (currently 87,674), but this can give a misleading representation of the current situation. I would just note that the number of cases is about 10% of 1% of 1% of the global population, or 0.001%. However, if we look at the geographical split of infections then we can see that 91% of global cases are in China and 74% of global cases are located in Hubei province where the virus originated. Looking at new infections, 99% of the new cases in China (29th Feb) occurred in Hubei with only 3 cases recorded in the rest of China. Whilst there is undoubtedly a bit of poetic license in the Chinese figure, it does emphasise the point that whilst the effects of the virus (from an economic perspective) are far reaching, the spreading of cases in China is minimal, a testament to the aggressive quarantining that China implemented. The view that China is managing the situation effectively is backed up by a relatively large reduction in deaths in China.
The other important statistic to take into account is the number of active cases, i.e. those that currently have the virus, not the ones that have recovered from it. As the graph below shows, this has decreased from c.60,000 to c.41,000.
The figure will clearly start to increase as the virus spreads through other countries, but I think it is important to note that this is not as bad as the media portrays it.
If I was to tell you there was an illness that each year infected between 340 million- 1 billion people and led to deaths of between 290,000 and 650,000 you’d understandably be scared. The markets would be petrified at the prospect of 15% of the world population being infected with an illness and the resultant impact it would have on economies. This of course is the seasonal flu. Just imagine if we all followed the number of flu cases on a case by case, day by day basis. Whilst this is not a perfect comparison, I do believe that the significance (at the moment) of Covid19 is being exaggerated and taken out of context.
As a result of fear gripping the markets, the UK market fell by over 11% (824 points) last week, with equally dramatic falls being seen in America and Asia. Trillions of pounds of value were wiped from equities in what was the worse week for markets in many years, and the quickest 10% fall American markets have ever seen.
Markets are beginning to suspect that the spreading of the virus to more countries will have a profound economic impact and resulting effect on the profitability of companies. This has to a certain extent been witnessed last week with dozens of companies warning the market that there is likely to be some short-medium term impact on revenue and profitability. The obvious sectors that are seeing significant weakness are those that have meaningful manufacturing and supply functions in China (Retailing and Automotive) and also where short term demand is being affected by the virus (Airlines, Hotels, Commodities). However, given that markets tend to react in a pretty indiscriminate way to bad news, whole swathes of companies that are unlikely to be affected by the Covid19 are falling sharply, such as housebuilders and banks.
The main questions for markets to decipher is the quantum of the economic impact and the likely longevity of it.
One of the shortcomings of stock markets is that prices move every second and that can lead to irrational and emotional responses by investors. If markets move lower, one might start to question their investments, be scared by potential future losses and sell their investments. This then creates a negative feedback loop, where the selling of investments causes prices to fall even further and encourages more investors to sell, causing prices to continue falling. Is this rational though? I would respond with an emphatic no for two reasons.
First, Investors usually invest their capital to generate good returns over the long term, to fund some future event such as retirement or passing assets onto their descendants. If this is the case, then why would one be focussed on short term volatility when you potentially have an investment horizon of many decades? I’m fortunate to be able to officially retire in 2057. I have not been selling equities, I have been buying.
Secondly, as prices are constantly moving in the market, it is very rare for prices to accurately reflect a company’s fair value. Are the long-term fortunes of most companies going to be affected by the spread of Covid19? I would say no. There may be some casualties in term of highly leveraged companies that are suffering serious falls in revenue, but generally speaking, companies will survive, and this will have no impact on them in the long term. People are still going to buy iPhones (Apple), people are still going to buy houses, people are still going to buy deodorant and mayonnaise (Unilever) and people are still going to drink Guinness (Diageo). So, if we assume that the long-term fundamentals of most companies are intact, then why would I sell shares when they’ve fallen by 11%? Surely, I should be buying shares as I can get them far cheaper. Who doesn’t love a bargain?
One metric that we like to look at is the ‘Yield Gap’. This essentially looks at the dividend yield on the UK market and compares is to the return on a ten-year UK government bond. As the below graph shows, this is the widest it has ever been. UK equities yield nearly 5% and government bonds yield about 0.45%. I know where I would rather have my capital invested for the future.
However, one could make the argument that is that dividend safe? I.e. will companies generate enough profit and cash to be able to pay a dividend to shareholders. The answer to the question is muddied a bit as it is not clear how much of an impact and for how long Covid19 will affect companies. However, the UK market currently has a dividend cover ratio of about 1.6x (for every £100 of dividends paid, the market generates £160 of profit) which gives companies a reasonable margin of safety to keep paying dividends, as profits would have to fall 37.5% for profits to not be able to pay current dividends.
Past performance also gives a reasonable indication that dividends tend not to fall unless there is a severe economic downturn such as the financial crisis in 2008. The below graph shows rising levels of dividend payments from the UK market over the years and the resilience of dividends (Nb 2014 was a very large special dividend payment and so not actually a reduction in dividend payments).
History also provides us some useful guidance as to how markets have reacted to other outbreaks of diseases in the past and this may give us an indication of what is to lie ahead. The below graph is a bit simplistic and doesn’t take into account other events that were happening in the markets at the time of outbreaks, but I think it does add something useful to the debate.
As can be seen, markets tend to respond negatively to outbreaks of disease in the short term, but over a period of months they tend to erase their losses and move even higher than before. This time does feel more serious than any of the other outbreaks and so the decline in markets may be sharper and it could take longer for markets to recover. The graph does illustrate another point though. Markets go up over the long term. Focus on the long term.
Now, this is not me saying that equity markets have reached the bottom yet or to pile everything into equities as of today. I don’t believe we’ve reached peak fear yet and it is difficult to know when we will. It is likely that it will come as more cases of Covid19 start to appear and more parts of the global economy start to slow down (e.g. more quarantines, cancellation of sporting events, shutting down of borders et cetera).
Nobody can predict when markets reach the bottom and with that in mind, I think this is definitely a good starting point to selectively dip a toe into equity markets. Purchasing good quality funds and equities where the long-term structural
growth story is unaffected by the virus seems like a sensible strategy. However, even though we believe equity markets are demonstrably cheap when looking at lots of different metrics, they could still get cheaper. For this reason, our purchasing of assets will be selective and in small increments. For example, if we see markets fall another 5% then we may top up equities by a certain amount, another 5% then another top up of equities et cetera.
It’s also worth putting this market fall into a historical context. Most years, the UK market suffers quite a severe fall during the year but finishes the year higher than it started. The below graph shows the intra-year declines of the market and the calendar year returns. On average, the UK market tends to fall 14% during the year, but more often than not it finishes higher than it started. Whilst the pace of this selloff has been pretty remarkable, the magnitude of it is not.
In a recent market commentary that I wrote over Christmas, I talked about the vast number of shocks the markets have experienced over the last ten years. The thrust of the article was that when you’re in the midst of one crisis or another it can feel like the end of the world, but they blow over and markets recover. These are some of the more pertinent words that I think are worth bearing in mind at the moment:
‘Yet here we are. The world is still turning, and the markets are celebrating the best and longest bull run on record. When you’re living through these events, they can be scary, and can seem like the most consequential events in memory. But they’re not. Now, of course they need to be analysed rationally, and you need to ensure that you’re well-diversified and positioned appropriately; but, in most instances, they sort themselves out and present good buying opportunities for the patient investor.
I occasionally wheel out a quote by Benjamin Graham, ‘the father of value investing’, who said that ‘In the short run, the market is a voting machine; but in the long run, it is a weighing machine’. I usually use this as a short-term reminder for one to be stoic in the face of market uncertainty but now use it to prove that it has been correct over the last ten years, correct over the last fifty years and correct over the last one hundred years. Patience is one of the best virtues an investor can have and will continue to be a powerful tool in this next decade.
I’ve got no idea what the coming year will hold, let alone the next decade. One thing I am sure of, though, is that there will continue to be highly significant and potentially scary moments for the stock market. These will provide opportunities for the patient investor and we believe that equities will continue to provide adequate returns above the level of inflation. This year may see volatility as our relationship with the European Union continues to evolve and the Americans undertake another election; but we continue to be positive about the long-term prospects for the world’.
This market is a bit scary and it might get scarier in the coming weeks. However, we are of the opinion that this does not change the medium to long term case for owning equities and we will be looking to take advantage of the continued irrationality and emotion that the market shows. The investments that we own have good long-term prospects and we are more than happy to buy these high-quality investments at far lower prices. I’m of the firm belief that markets will recover from this setback and we will look back on this volatility as a period that presented good investment opportunities.
If you’re sitting on large amounts of cash, then this may be an opportune moment to top up portfolios and take advantage of the weakness that we are experiencing. Please get in touch with your usual BRI advisor if you have any further questions.
Chief Investment Officer